Will Cable Get Pounded?

Last year, the pound was soaring to all time highs against the dollar. However, when the financial crisis hit the US, it was as quickly that the UK was just as exposed, if not more so. Risk aversion reigned and every investment that was deemed risky crashed as global investors fled to safety.

For the last three months, this trade has been in retracement mode. And the further it retraced, the more it has fueled optimism in the outlook for a recovery. Even commodities finally showed some life, which as a result, the US dollar and 10-year Treasuries have been sold. Also, noting Washington’s mushrooming deficit, generated by massive government borrowing to fuel its economic recovery plan.

Nevertheless, in the face of this strength, the cable has to deal with two harsh blows.

Firstly, two weeks ago, Standard and Poor’s downgraded the outlook of UK’s AAA credit rating, yet the pound proceeded to rally over 7% in the following weeks.

Secondly, the political scandal struck when members of Prime Minister Gordon Brown’s cabinet were exposed for personal spending jaunts with taxpayer money and the subsequent series of resignation of senior members of ruling Labour party from cabinet following a call for Brown to resign.

Well, at one hand, the strength of pound to a great extent had everything to do with the across-the-board retracement of the collapse of the US dollar, but I sense the wholesome retracement in financial market has reached some very significant inflection points and this feed-good rally may have run its course, if we see further signs of green shoots.

My concern is that when confidence is being manufactured by a rising stock market in simple retracement mode during the worst economic period since the Great Depression… look out for sharp sell-offs in currencies, commodities at the same time. For currencies, when this rally subsides, the biggest gainers are likely to experience the sharpest declines. As for the pound, it is already feeling the heat.

Bottom line – we could already entering Round 2 of the risk aversion trade and that could mean major downside for pound and possibly the AUD as it has climbed 31% in three months, tracking the US stock market closely all along the way.